Gold: Stocks vs Bullion


There’s a curious phenomena in the gold market right now. After many months of out performance, bullion is still outperforming stocks. In previous years, bullion and stocks see-sawed in performance, as one led strongly, the other followed in turn. Not so this time. Bullion has been the overwhelming winner in asset class whereas stocks have done little better than to just preserve wealth.

Note the bottom red line of the range represents how inexpensive stocks are to gold and the top red line represents how expensive stocks are to gold bullion. In late 2008, gold stocks hit their all time low relative to the price of bullion and although gold stocks have had a good rally, relatively, they are still at 50 year lows of relative value.

I think its due to a few factors including the lack of buying… With advent and popularity of gold ETFs, the difficulty in owning bullion has never been easier. As well, the management volatility quotient prevalent in gold companies is just not a factor in bullion. In bullion there is no exploration risk, no fraud, no mine salting, no lack of liquidity, no cheap management below market options there to reward management who has little or no stake in the company etc etc. With bullion there is a benign management bias – ie no net present value of a managements ability to deliver results. Just the metal…

With bullion, for example GLD the most popular gold etf, there is immense liquidity. A hedge fund, mutual fund, institution etc can make a relatively massive stake without impacting the near $72B market capitalization of GLD. In previous years, most stake holders would have gotten their gold exposure through gold stocks – now there is competition.

That being said, if you look at gold stocks through the lens of a value investor, this asset class is starting to look quite appealing. I think, on average one can guesstimate cash costs per once of gold around $500 and with gold at $1000/oz they would be quite profitable. At $1800/oz most gold companies, quite literally, are printing money. And they now are in a conundrum that most successful companies can find find themselves in. And that is, what to do with all that cash…

Classic cash flow analysis will tell you theres only a few things management can do with the cash: pay down debt, buy back stock, pay out dividends, expand capital expenditures or look for opportunities.

My thesis is that what we’re about to see is a cascade of merger and acquisition type of activity. Gold companies have a poor record of paying out dividends as the earnings volatility is too high. Most companies typically dont have alot of debt as banks find them difficult to finance and equity markets have been eager to finance via issuing stock. ergo not alot of debt to pay down.

Buying back your stock is a question of metrics and the best use of your capital. If your company trades at a higher valuation multiple than a competitor in the marketplace and there is potential economies of scale then it makes good investment sense to purchase your competitor. If you trade at a discount to industry metrics then it makes sense to buy back your own stock.

Right now, there is a disparity between the valuations producers are getting the marketplace  versus the explorers. I’m guessing that smart management of a typical producing gold company would look at leveraging their overvalued metrics and utilizing the cash at purchasing an undervalued close to production/significant proven reserve type company.

It is this series of event that i think will spark the coming rally in junior golds. See our upcoming  newsletter for our picks in this sector!

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